Korea shocks with rate cut but will it work?

Emerging market investors may have got used to policy surprises from Turkey’s central bank but they don’t expect them from South Korea. Such are the times, however, that the normally staid Bank of Korea shocked investors this morning with an interest rate cut, the first in three years. Most analysts had expected it to stay on hold. But with the global economic outlook showing no sign of lightening, the BoK probably felt the need to try and stimulate sluggish domestic demand. (To read coverage of today’s rate cut see here).

So how much impact is the cut going to have? I wrote yesterday about Brazil, where eight successive rate cuts have borne little fruit in terms of stimulating economic recovery. Korea’s outcome could be similar but the reasons are different. The rate cut should help Korea’s indebted household sector. But for an economy heavily reliant on exports, lower interest rates are no panacea, more a reassurance that, as other central banks from China to the ECB to Brazil ease policy, the BoK is not sitting on its hands.

Nomura economist Young-Sun Kwon says:

We do not think that rate cuts will be enough to reverse the downturn in the Korean economy which is largely dependent on exports.

Exports make up 53 percent of South Korea’s economy, World Bank data showed last year. That’s one of the highest rates in the world, far higher than China’s 29 percent or Brazil’s 12 percent. Nearly half these exports went to China. Europe and the United States — growth is looking shaky in all these destinations. Look at the figures to see how this is affecting Korea. Exports grew 19 percent last year. But in 2012 export growth is estimated at 3.5 percent, half government’s initial forecast. And correlation is high between exports and manufacturing — no wonder Korean factory activity shrank in June for the first time in five months.

Rather than reassure investors, the rate cut appears to have spooked, with stock markets falling more than 2 percent and many analysts criticising the BoK for surprising markets.

There could be a bright side. The won fell 1 percent after the shock announcement. It has been flat this year against the dollar while other Asian currencies, including China’s yuan, have lost ground. If the BoK stays dovish (which looks likely) and the won weakens more, that could help exporters compete better with Asian rivals. As Nomura’s Kwon says, ultimately the cut could limit downside growth risks via “confidence and foreign exchange channels”.